Macro-Economic Environment
We have made the case that much of the recent rally in both stock and bond markets were due to a surge in liquidity derived from an unleashing of previously dormant cash reserves. Concurrent with this onslaught of cash hitting the market was a resurgence in the soft-landing narrative in which inflation gently glides back to the Fed’s 2% forecast amidst a slight uptick in unemployment. We give very little credence to either inflation staying on a smooth glide path back to 2%, or that the economy will sustain little damage from the sharpest rate increases in history.
As with all forecasting, sometimes the environment shifts in such a way as to immediately bring your assumptions into question. The Fed meeting on Wednesday, quite unexpectedly, represented just such a move. This Fed meeting was expected by most, including us, to be largely a non-event with the Fed holding rates steady and promising to be “vigilant”. Instead, Chairman Powell took this opportunity to make sure the market came away with three important developments: 1.) The war on inflation has essentially been won; 2.) The war did not necessitate a severe downturn in the economy; 3.) Rate increases are no longer in the Fed’s immediate arsenal.
In layman’s terms, Powell said: We won. The fight is over. It didn’t cost us much in terms of real growth and we can now afford to be more accommodative.
The reaction by all capital markets to the above was akin to throwing additional gasoline on an already liquidity driven inferno. Most of the response in the bond markets was felt at the short-end with the 2-Year Note dropping over 30 basis points immediately. The equity markets followed suit with essentially every sector participating, particularly the deep cyclicals.
The Fed Chair made a concerted effort to state that the Fed is aware of the need to cut rates before the inflation numbers reach the 2% target, given the policy lags involved. However, he also said that they would be prepared to raise rates if inflation didn’t behave as expected (it wouldn’t be a Fed meeting if there wasn’t at least some ambiguity).
While the bond markets were caught off guard by the degree of certainty expressed by Powell on the inflation front, perhaps the Fed has suddenly become more concerned by developing economic weakness than ongoing disinflation. What markets might the Fed be looking at that caused them to shift policy at this point in the cycle? We suspect that they may be focusing on commodities broadly in determining the level of real economic weakness.
We have always been of the belief that if forced to rank markets in terms of forecasting credibility the result would be: 1.) Commodity Markets; 2.) Bond Markets; and a distant 3.) Equity Markets. By forecasting credibility, we look toward markets that contain the greatest ties to actual economic activity. The physical nature of commodities as inputs into the productive economy means that their prices are primarily driven by supply/demand dynamics rather than narratives. Speculative excesses can occur in commodity markets, but not for long as they are almost always upended by the realities of true fundamentals.
If commodity markets are to be believed, then the global economy is potentially in trouble. A look at the most economically sensitive commodities - industrial metals and oil - would suggest that they are reflective of the weakness that is potentially worrying the Fed.
Industrial Metals: The prices of almost all base metals experienced reasonably significant declines for most of the year. While a good deal of this weakness can be explained by the ongoing drag from weak Chinese demand, the broad-based nature of this selloff suggests that the slowdown is more pervasive. The large global miner Anglo American has seen its stock price fall by over 50% this year.
Oil/Diesel: Implied U.S. distillate demand (diesel) fell to the lowest seasonal level since 2009 in the latest weekly report. Diesel crack spreads have also fallen sharply this year based on weakness in global consumption. This is key as diesel and gas oil consumption make up 30% of total global crude demand. Thus, crude oil prices have been negatively impacted over the last 3-4 months.
Despite noted weakness across most of the commodity complex, we are selectively bullish on commodities…given this most recent Fed announcement. While inflation has come down of late, it is way too early to be declaring victory. We can envision a scenario whereby inflation remains sticky and bounces around the 2-4% level. If this were to occur amidst a Fed that is cutting rates, the Dollar would most likely suffer. This in turn would be a tailwind for hard assets, bad for bonds and equities.
Takeaways: The Fed has boxed itself into a corner with this most recent pronouncement that the war on inflation has essentially been won. There are historical precedents which show that claiming early victory has been the trademark of situations where inflation becomes more entrenched. If the Fed starts to cut rates on the backs of this belief, we see commodities/hard assets as the biggest beneficiary of such a move given the likely negative Dollar response.
Commodities/Energy
Consolidation continues in the oil patch, with OXY acquiring privately-held and Midland Basin-focused CrownRock for $12Bn ($9.1Bn Cash, $1.7Bn Equity, $1.2Bn of Debt Assumption). The initial “tell” was the OXY jet heading due north and landing in Omaha, the location of OXY’s largest shareholder Berkshire Hathaway, in late-November. While it doesn’t appear Warren (Buffett) assisted in financing the transaction, Berkshire followed soon thereafter with another large OXY share purchase…10.5Mn shares totaling $592Mn. This brings BRK’s ownership stake to over 27% of the upstream producer and at ~$14Bn market valuation, it’s BRK’s 6th largest holding.
We feel the ongoing consolidation will result in a tempering of domestic production as more acreage/locations come under the control of larger publics who need to remain disciplined. Managing the drilling pace will be essential in returning an adequate amount of capital to shareholders in a yield-competitive environment. Tier 1 acreage is becoming more difficult to come by, thus the increased number of mega-transactions focused on high-quality independents in the Permian.
Hollub & Co. at OXY didn’t buy CrownRock on the cheap however, and are now confronting a futures curve that’s flipped into contango. This generally implies a near-term over supplied market, a situation also reflected in the 21% price decline (Brent) since late-September. In fact, recent pricing is flirting with the lows for the entire year. This seems rather counterintuitive given that the two major ongoing conflicts involve a Top-3 global oil producer (Russia) and proximity to the heart of Middle East production (Israel).
Takeaways: The commodity market risks to an economic slowdown have largely been ongoing whereby the equity markets appear oblivious. No matter what type of economic “landing” occurs, commodities provide a much more reasonable margin of safety, with immense opportunity in select sectors.